Demonetisation and budgets: all in the mind
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It’s 690 seats this year; another 964 seats are up for grabs next year, with the general election to follow in 2019. This inescapable political imperative will weigh on finance minister Arun Jaitley’s mind when he drafts India’s economic policy. The battle for occupying popular mindspace over the past two months is now telescoping into a two-year battle. And if the vast majority of Indians feel confounded after Prime Minister Narendra Modi’s surgical excision of 86% of currency, they shouldn’t despair: They are in the distinguished company of Jaitley who, presumably, is equally disconcerted.
Jaitley will soon be presenting the 2017-18 budget and his well-laid plans may have to incorporate demonetisation-induced changes, over and above those included for introducing the goods and services tax (GST) system. What’s worse, with the GST start likely to be postponed, revenue projections may now have to be recast along traditional lines. Two huge changes in three months is more than just a rude disruption.
Two other elements add to the confusion. One, the railway budget will be merged with the Union budget this year in a meaningful break from a meaningless tradition. Also, the traditional expenditure reporting format under the broad heads of Plan and non-Plan expenditure will be jettisoned.
Standing for a moment in Jaitley’s shoes, what’s likely to be more worrying is how the economic slowdown affects revenue growth and how that shapes spending plans—especially committed social sector or infrastructure expenditure—that cannot be trimmed, leave alone eliminated. Jaitley has already promised higher government pump-priming to boost economic growth. Many new variables have cropped up in the meantime, further skewing the math. Modi contributed gamely during his 31 December speech with promises to increase social spending under both new and old schemes.
For example, new interest subventions on small housing loans and farm loans or increases in the number of rural houses built for the poor under the Pradhan Mantri Awas Yojana are some of the schemes which might expand both capital and revenue expenditure bills for 2017-18. It is clear that Jaitley has little option in slashing the outlay for social sector schemes, especially when demonetisation has eroded rural incomes and the ruling Bharatiya Janata Party is unable to dismount the election treadmill. Apart from state assembly elections for Uttar Pradesh, Punjab, Goa, Uttarakhand and Manipur in less than a month, next year will see elections in Tripura, Rajasthan, Madhya Pradesh, Karnataka, Chhattisgarh, Nagaland, Mizoram and Meghalaya.
With the political economy constraining deep spending cuts—at the most, outlays might be shuffled around under different schemes—revenue generation becomes imperative for meeting many of the grand spending plans. This is where rubber hits tarmac.
The demonetisation narrative focused on cornering tax evaders and, through legislative amendments, forcing assessees depositing unreported incomes to pay higher penal rates. This would require enhanced tax scrutiny and inevitably involve some element of persecution. But by stating that demonetisation was launched to punish currency hoarders, it subjected the majority to widespread suffering for the misdemeanours of a few. The messaging was subsequently imbued with nationalist overtones and repurposed to focus on moving India to a less cash economy.
Also read: Sequencing economic disruption
Enter the good cop: News reports claimed that Jaitley had hinted at lower tax rates in a meeting with tax officers, citing how similar attempts earlier had met with success. News leaks from unidentified finance ministry sources also made similar claims.
Jaitley later seemed to deny his statement without actually denying it. There’s no text of Jaitley’s speech; only a summary is available, which has him stating there was an urgent need for a change of mindset: “India has to move towards a mindset of voluntary compliance…payment of legitimate taxes should be considered as part of the process and nobody should think that tax evasion is acceptable.”
This is where things get muddied up. By using the term “mindset”, Jaitley pivots seamlessly into the arcane world of behavioural economics. It is reassuring to note that Jaitley recognizes the importance of mindset in correcting tax compliance behaviour. But his public musings betray a contradiction. Initiating mindset change is a long-term project which involves altering social norms using a combination of psychological and social forces. The post-demonetisation regime instead uses a carrot-and-stick approach: simultaneously offering incentives (aka the Laffer curve) and disincentives (penalties).
The World Bank’s World Development Report 2015—titled “Mind, Society And Behavior”—states clearly that penalties or incentives have failed to improve tax compliance across the world. The UK government’s behavioural insights team, also known as the “nudge unit”, claims to have used behavioural sciences successfully to improve tax compliance in the UK and other countries. Jaitley will do well to remember that like liquor prohibition failed to stem alcoholism and related social problems, a one-time demonetization (or a subsequent penal regime) might not be enough to raise tax revenue on a sustainable basis. While the impact of behavioural sciences in influencing policy outcomes is still imprecise, one thing is clear: lasting changes in social norms require long-term investments.
Rajrishi Singhal is a consultant and former editor of a leading business newspaper. His Twitter handle is @rajrishisinghal.